Pricing Options on Commodity Futures: The Role of Weather and Storage

Options on agricultural futures are popular financial instruments used for agricultural price risk management and to speculate on future price movements. Poor performance of Black’s classical option pricing model has stimulated many researchers to introduce pricing models that are more consistent with observed option premiums. However, most models are motivated solely from the standpoint of the time series properties of futures prices and need for improvements in forecasting and hedging performance. In this paper we propose a novel arbitrage pricing model motivated from the economic theory of optimal storage, and consistent with implications of plant physiology on the importance of weather stress. We introduce a pricing model for options on futures based on a Generalized Lambda Distribution (GLD) that allows greater flexibility in higher moments of the expected terminal distribution of futures price. We use times and sales data for corn futures and options for the period 1995-2009 to estimate the implied skewness parameter separately for each trading day. An economic explanation is then presented for inter-year variations in implied skewness based on the theory of storage. After controlling for changes in planned acreage, we find a statistically significant negative relationship between ending stocks-to-use and implied skewness, as predicted by the theory of storage. Furthermore, intra-year dynamics of implied skewness reflect the fact that resolution of uncertainty in corn supply is resolved between late June and middle of October, i.e. during corn growth phases that encompass corn silking through grain maturity. Impacts of storage and weather on the distribution of terminal futures price jointly explain upward sloping implied volatility curves.